There’s a reason “trade buyer” is music to a seller’s ears.

Even the most shrewd, disciplined real estate investors can get lured into the Exchange Trap. With a deadline looming, price gets thrown out the window and an exchange (or “trade”) buyer can become truly price insensitive.

Avoiding the trap requires strict discipline and an acute awareness of that age old economic axiom: TNSTAFL (there’s no such thing as a free lunch).

But first, a reading from Section 1031 of the United States Internal Revenue Code:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

In plain English, if you sell a property and use the proceeds to buy another, similar (“like-kind”) one, you can defer the capital gains tax that would have been due if you had just cashed out. There are, as one might imagine, a boatload of rules associated with this kind of transaction. A good summary can be found here, but anyone seriously interested in exchanging property should consult the CPA, attorney and a reputable 1031 exchange facilitator.

A 1031 exchange is nothing but a loophole. A well-documented and completely legal one, but a loophole nonetheless. After all, what other asset class allows for the potentially indefinite deferment of tax on profits? Thank the well-funded real estate lobby for that one.

Think about it this way: for every $100 in profit on sale, state and federal capital gains tax could run as high as 30% (especially if you live in our fair state of California). If you could have compounded that $30 at even 5% for 20 more years, you’d have $80. Add a few zeroes and it’s easy to see why 1031 exchanges are the preferred way to sell for many savvy real estate investors.

The rub is that these benefits alter the way a trade buyer looks at a potential investment. An exchange buyer can count these tax benefits towards potential upside on the new deal, which means that exchange buyers should be, and are, willing to pay more for any given property than a regular buyer.

But add on the timelines that must be met to qualify for the exchange and trade buyers can quickly go from opportunistic to motivated to desperate. And for sellers, that’s the best kind of buyer. The fact that most of our best sales have been to exchange buyers gives me pause each time I’m out there looking for a trade.

Here are five tips for avoiding the Exchange Trap in a market as tight as San Francisco’s, especially right now:

 

1) Start Your Search Early

It can become a bit of a juggling act, but don’t expect 45 days to be enough time to find your replacement property. Get your brokers or other sourcing outlets warmed up before the clock starts ticking.

 

2) Negotiate Close of Escrow Extensions

When selling, negotiate in close of escrow extensions to give yourself more time to find a replacement property. Even if you have to pay for it (read: accept a lower price with better terms), flexibility to find – and not have to overpay for – the right replacement property is worth every penny.

 

3) Apply Your Standard Criteria First

Whatever your preferred metric or benchmark for evaluating deals, don’t stray until you have to. Evaluate a replacement property as a standalone deal and then, only then, apply some premium for the benefits of the exchange. It’s tempting to juice your model to make the replacement seem better than it is, but here’s where that discipline you’re so proud of really counts.

 

4) Look Outside San Francisco

Want to lock in profits while focusing on other more labor-intensive deals? Try expanding your search to higher cap rate areas outside San Francisco or even outside the Bay Area. This may seem like sacrilege to us snobs who only buy in the city, but a steady passive cash flow stream could help fund your next hairball.

 

5) Be Willing to Take Your Medicine

It’s OK to take profits (you can’t take them to your grave anyway), pay the tax man and move on. Don’t get married so married to the tax game that you lose sight of what put you in this enviable position in the first place. When in doubt, heed the wise words of Charlie Munger:

 

“I see terrible mistakes from people being overly motivated by tax considerations.”

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